Bank to keep us guessing on rates

OTTAWA -- Traders hope next week's interest-rate decision from the Bank of Canada settles the debate as to whether the central bank's first rate hike in nearly three years comes in June or July.

Some observers warn, though, that the central bank might keep people guessing.

"The reality may be somewhat messier, with quite a number of viable scenarios, and the most likely outcome [is] that the central bank elects to leave both options open - to be settled by incoming economic data," said Eric Lascelles, chief Canadian strategist at TD Securities.

It will be a big week for Mark Carney, the Bank of Canada governor, with the rate statement on Tuesday, followed two days later by the release of the central bank's latest economic outlook, which is bound to incorporate the robust data emerging not just in Canada, but the United States and the rest of the globe.

Markets, through bankers' acceptance futures, have priced in a 100% chance that the rate hike comes in July, allowing the central bank to fulfill its conditional commitment to maintain its 0.25% rate until the end of the second quarter. But those same instruments have priced in a 50-50 likelihood of a June increase.

Pressure on Mr. Carney to move in June has mounted in recent weeks, especially on news that inflation is stronger than the central bank had forecast, and a sharp upturn in inflation expectations among firms.

Core inflation in February surpassed the key 2% mark, while headline inflation remained above

The yield on the two-year Canada bond now stands at roughly 1.92%, for a spread of nearly 170 basis points against the Bank of Canada benchmark rate. Yanick Desnoyers, assistant chief economist at National Bank Financial, said history dictates rate hikes emerge once that spread reaches 160 basis points. (Higher yields generally forecast higher inflation down the road.)

"How can you justify a yield curve that is calling for rate hikes," said Mr. Desnoyers, who is among those calling for a June move.

Still, the consensus among private sector economists is that the Bank of Canada will wait until July. Even though inflation is stronger than expected, analysts note that's likely due to one-off factors such as the Winter Olympics, which will no longer be accounted for in future readings.

Further, an early rate hike could spark a sudden surge in the Canadian dollar, as the U.S. Federal Reserve has indicated no plans to raise its policy rate any time soon as inflation in that country remains tepid and unemployment relatively high.

"The Canadian dollar has to be a consideration for the Bank of Canada, and is the main reason we think it will wait until July," said Sal Guatieri, senior economist at BMO Capital Markets.

Sheryl King, head of Canadian economics strategy at Merrill Lynch Canada, said it would be best if the Bank of Canada began rate hikes in June, and take a "low and slow" approach. One option mentioned – that the central bank waits until July and undertake a 50-basis-point increase at that time – is "crazy talk," she said, as the market would then expect all future hikes to be similar in size and drive up long-term yields in "a heartbeat."